Inflation Expectations and the Commercial Real Estate Sector | Lord Abbett
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Fixed-Income Insights

Heightened inflation fears, coupled with an upward move in rates, has various implications across property types and geographies.

Read time: 2 minutes

The recent sell-off in U.S. Treasuries has led to some of the highest rates seen in quite some time, especially at the long-end of the curve. We believe the selling has been triggered by increased optimism regarding the strength of the U.S. economy, combined with a more aggressive timeline for COVID vaccination distribution relative to expectations. Another factor in the upward move in rates is increasing inflation fears, particularly given the $1.9 trillion stimulus plan which just recently passed the U.S. House of Representatives.

The market has reacted swiftly, with a meaningful turnaround in inflation expectations from a year ago (see Figure 1). (Read additional insights on inflation expectations and interest rates here.) This may have significant implications for the commercial real estate market. While commercial real estate has historically performed well in inflationary environments, we do not expect performance to be similar across all industry segments during this cycle. 

 

Figure 1. Breakeven Inflation Expectations Have Climbed
U.S. five-year inflation breakeven rate, March 2020 through February 2021

Source: Economic Research Division, Federal Reserve Bank of St. Louis. Data as of February 28, 2021.  The TIPS/Treasury breakeven rate is calculated as the difference between the 10-year U.S. Treasury rate and the 10-year U.S. Treasury inflation-indexed security rate. For illustrative purposes only.

 

Historically, commercial real estate has been viewed as an asset class that benefits from inflationary regimes. Inflation usually means rising prices and wages, and in turn rising rents and property values for commercial property owners. However, for an industry that continues to battle the lingering effects of the COVID pandemic lockdown, the impact is more uncertain. Additionally, certain tenant segments are undergoing significant structural challenges that are reducing demand and in turn pricing power for commercial real estate.

We expect that the push and pull between these crosscurrents will set the tone in the asset class for the foreseeable future. As a result, we think there may be meaningful variation in performance across property types and geographic regions, based on an owner’s ability to pass through the inflationary impact of their expenses to tenants.

An example of this divergence in these expected returns is in hotel versus retail properties. Modest economic growth and an inflationary environment should support outperformance in the hotel segment, while retail property returns will likely lag. Owners of hotels typically can reset the pricing of their leases (e.g., room rates) on a daily basis, exhibiting a high correlation coefficient with inflation. Additionally, travel demand has slumped well below what we would expect to see in a normal recession due to COVID-related travel restrictions and lockdowns. We see the potential for a surge in demand as early as the second quarter of next year, helping to drive upward pressure on room rates.

Conversely, owners of retail properties face two meaningful challenges. First, the term of retail tenant leases tends to be longer than most other property types. Secondly, retail tenants are facing mounting business and financial pressure due to the secular shift to online shopping.  With a growing number of retailers reducing their store footprints, a retail owner’s ability to push rates higher has been significantly eroded.

A Final Word

Lord Abbett’s investment team has been factoring in these market dynamics and dispersion of potential outcomes in our evaluation of securities, both in terms of deal selection and monitoring of existing holdings. Over the course of this year, we have reduced exposure in holdings that are sensitive to rising interest rates and properties that we believe might face additional stress in an inflationary environment. We will continue to actively manage our exposure in commercial real estate, paying careful attention to interest rates and inflationary trends.

 

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education.  No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein.   If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in the preceding commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

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